Month: March 2010

The Problem with International Growth

Best Buy is a multinational firm with operations in the United States, Belgium, Bermuda, Canada, China, France, Germany, Ireland, Luxembourg, Mexico, the Republic of Mauritius, the Netherlands, Portugal, Spain, Sweden, Turkey, Turks and Caicos, and the United Kingdom.  Sales are split 75%/25% domestic (US) and international.   Asset investment approximates this with a rough 60/40 spread between domestic and international.  Profits are a different story.  Operating profits domestically were 5.6% in 2009 while international operations were at 1.5%.  That means 93% of profits are driven by domestic operations and only 7% internationally.  On a return on investment basis, international then uses 2.7x more investment to generate a dollar of sales and each international sales dollar generates about 70% less profits than a domestic sales dollar.

An illustrative example can help us understand these underlying numbers.  A domestic investment of $250 should generate an increase of $1000 in sales, which will generate $56 in profits and a 22.4% return on investment.  The same investment internationally will cost $680 to generate $1000 in sales.  This investment will return $15 and generate a 2.2% return on investment.  To generate the same profits internationally as our $250 investment did domestically we’d have to invest $2.500.

A possible reason for Best Buy to invest so much in the international business is the eventual returns they will generate.   The evidence doesn’t support that conclusion.  When the domestic business had the same level of investment as does the current international operations it was 2007 and the operating profit rate was 6%, approximately 4x where the international segment is now.  When the BBY domestic segment was at $9b annual in sales (1998) the operating income rate was 3.5%.  So neither investment size nor additional sales will give investors comfort that the BBY international segment returns are likely to increase.

US based retailers have a long history of wasting capital in international expansions.  Starbucks, Wal-mart, Borders amongst others have pulled out of overseas operations in the past few years.  There are some very good reasons for these investments failing.

First, the US is a very large relatively heterogeneous market.  Although the world is getting smaller, it isn’t small enough so there aren’t some product and business model issues that have to be changed by country.  Those changes require extra merchandising support, local distribution and local management. The size of the US market creates low overhead costs.  That is not true internationally. The management team you hire in Canada cannot manage Mexico also.

Secondly, the US is wealthy and doing business here is relatively efficient.  Consequently retailers here generate strong returns.  Moving away from a high return market is always going to be unattractive, every incremental dollar looks less effective. Comparing capital investment in the US with capital investment in the international segment is a bit misleading.  Reaching a similar capital investment for the opportunity might require 2-3x more capital internationally than in the US.  Although Best Buy has invested $6b in their international operations, they have only achieved a very small international market share vs their US share.

Thirdly, retailers in the US live on low paid workers which have relatively high levels of turnover.  This is not the employment model that Europe follows.  Although Best Buy does not have very high employment turnover, their number for this last year was 36%.

Fourth, international growth is rarely organic.  If you have to buy your way into a market you end up paying market price.  Organic growth is about adding value by putting together parts (merchandise, systems, processes, people and real estate), not through acquisitions.  Adding value to an acquired asset is more difficult.  Incremental sales are harder to generate, incremental profit opportunities are usually have lower gross margins or higher inventory requirements.

Finally, real estate costs are higher internationally.  This is due to land use decisions and issues related to ownership and development of property.  Landlords internationally take more of the profit equation than landlords in the US, usually because the competition for space is greater.  When landlords have multiple bidders for the same space, they will end up with higher rents and a higher portion of the value added created by the retailer.

So why does a management team continue to invest in growth when the returns are so poor?  Best Buy’s management team has a web-site that speaks to why they want to continue to grow.  Sometimes growth becomes such a part of a firm’s self-image that they continue to do so well after the investments make sense.  I don’t know if that is the case at Best Buy, but the return on investment results don’t look good.

Management and the Self Attribution Bias

People often boast about their efforts when things are going well and place the blame elsewhere when things are going poorly.  This is called the self-serving or self attribution bias.  This tendency to think the best of ourselves and attribute good performance to our hard work helps us maintain high levels of self-esteem.   Assigning the responsibility for poor performance to some external factor also helps maintain an idealized picture of oneself.  To the extent that you exhibit this bias you probably go through life a little happier about your accomplishments (you deserved them) and take the bad experiences less personally (after all when bad things happen –it’s not your fault) than most.  For the most part this bias is really only annoying if you live with a teenager, as they are especially good at avoiding responsibility.

Management teams also sometimes show this bias.  Williams-Sonoma’s (WSM) management team for example is clearly taking credit for the recent good news after avoiding responsibility for the earlier bad news.

Last year when comparable store sales turned negative on the third quarter conference call, Howard Lester, Chairman & CEO, noted that “during the third quarter, the unprecedented downturn in the US financial market had a significant impact on our business.”  Lester on the call also pointed that “the stores look terrific” and that “by and large, this thing is more macro now”.  On the same call Dave DeMattei, the then Group President of Williams-Sonoma, and Sharon McCallum, CFO, both commented on the “these difficult economic times”.   Although the management team admitted that merchandise could always be improved, the clear message was that the bad numbers were due to the economy.

During this years’ Q4 conference call the incoming CEO and current President Laura Alber noted in her discussion on Pottery Barn that “Comparable store sales increased 11.5%, and authoritative cohesive assortment and compelling price points, combined with a highly effective inventory management strategy  drove these significantly improved results.”   Alber doesn’t mention, of course, the fact that comparable store sales were down 29% at Pottery Barn during the same quarter last year.  So if you’d ended Q4 2007 with $1,000 in sales, you’d now have $792in sales, clearly not a significantly improved result.  Lester also commented “year-over-year growth trends once again sequentially improved, which validates for us, the effectiveness of our merchandising and marketing strategies that were deployed during the year”.   WSM’s overall comparable store sales were 7.6% in the fourth quarter following a negative 22% last year.

The downside of the self attribution bias is that it distorts the participants understanding of the circumstances.   In the case of Williams-Sonoma, the high compensation for the management team is ostensibly due to their skill at running the business.  If a significant part of their performance in the 2002-2007 time period was because of the housing boom and not management diligence then the shareholders have been poorly served.   WSM sales are down significantly from 2006 and 2007; this is clearly a smaller and less profitable business than it was two years ago.  Interestingly, the stock price today is $2 higher than it was at the end of 2008 when profits were almost 2.5x higher.

Of course the most obvious alternative explanation for the “significantly improved results” might just be the improving economy.  Comparable store sales across the board were better for retailers in Q4 this year and WSM’s recovery wasn’t really exceptional or significant.  It was expected.